First, lets set things straight. Credit Default Swaps are fradulent to begin with: Financial Carcinoma -- Denninger: Did You Need a PhD For That? - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=322718. But just because they are fradulent does it mean they will go away? No

But what I am more concerned with is the distinction between inherently fradulent instruments (Credit Default Swaps) and OVERTLY fradulent instruments (Naked Credit Default Swaps).

What is a Credit Default Swap?

It is when you have exposure to debt and you want to buy insurance against that debt defaulting.

What is a Naked Credith Default Swap?

It is when you have no exposure to said debt but you are buying insurance against in anyways.

Though credit default swaps have existed for only a relatively short period of time, the debate they evoke has parallels to debates as far back as 18th Century England over insurance and the role of speculators. English insurance underwriters in the 1700s often sold insurance on ships to individuals who did not own the vessels or their cargo. The practice was said to create an incentive to buy protection and then seek to destroy the insured property. It should come as no surprise that seaworthy ships began sinking. In 1746, the English Parliament enacted the Statute of George II, which recognized that “a mischievous kind of gaming or wagering” had caused “great numbers of ships, with their cargoes, [to] have . . . been fraudulently lost and destroyed.” The statute established that protection for shipping risks not supported by an interest in the underlying vessel would be “null and void to all intents and purposes.”

It is fraught with conflicts of intrests (i.e. Goldman Sachs and the Greek CDS scandal).

But here is where my title comes from:

The Economist has an article on CDS's here: Smokescreen. And they have an argument that tries to justify the practice of naked Credit Default Swaps:

Even so, surely it cannot be right for people who do not own any government debt to profit from sovereign distress? Actually, it can. When states get into trouble, other borrowers suffer too: taxes rise, economies slow. So investors in Greek companies have legitimate reason to protect themselves against Greek sovereign risk. If they cannot, they will simply charge companies a higher risk premium instead. Buyers of protection also have to find sellers—banks, say, or hedge funds. But sellers want to offload their risk as well. If sellers are not allowed to buy protection themselves, investors will find it harder to hedge. If so, banning naked CDSs could end up making it more expensive for governments to borrow.

(emphasis mine)

.... INTREST RATES ACROSS MANY ECONOMIES AND MARKETS ARE **ALREADY TOO LOW!!**. In fact, practices like Naked CDS's are arficially changing the environment in which government debt is priced! Governements need to by and large cut back on borrowing in the first place! Naked CDS's are distorting all kinds of natural market signals

I think making an "insurable interest" a requirement to buy a CDS is absolutely needed. It's the same as letting me buy a life insurance policy on you when I have no loss in your passing. I now suddenly have a financial interest in your demise.

If you have naked CDS exposure, and the entity does not default, then what are the ramifications? I'm trying to discern naked CDS exposure and shorting shares of a company without owning shares of a company...

Actually a CDS contract is a lot like a put option contract and displays alot of the same characteristics. I would think if you have a naked CDS contract and the company doesnt fail the "contract" would become worthless.

With naked short selling of equities, the books at the end of each day among brokers are balanced and it the naked short seller doesn't get prior permission to borrow and the short seller sells to a buyer, then there will be a Failure to Deliver when the books get balanced.

The equity markets are reasonably well regulated for this to be a widespread occurence.

But the CDS market is absolutely opaque.

Sell of CDS insurance can re-sell their swaps. E.g. I can take out insurance, and sell it to somone else, and they can sell it. And the trail is much less clear and *very* open to manipulation. It is quite literally a black market. I quite honestly do not know the ramifications if one buys a Naked CDS and it doesn't default. Who gets audited if the instument expires worthless? What is the paper trail?.

But the Fed wants to legitimize this overtly fradulent behavior when it should end the practive althogether. But when you have an easy money policy, these are the games that get invented. And two wrongs do not make a right.

All Credit Default swaps should have to go through a clearing house. It wouldn't stop the lunacy, but at least it would shine some light into the darkness. These things scare me more than the Govt. debt, as far as damage to the economy goes.